UK risk premium looks too steep with stability restored

October was a tumultuous month for sterling assets, but the past week has brought some welcome stability.

A quick recap for those who don’t follow UK politics particularly closely. The backlash which followed the Conservative government’s ‘mini-Budget’ on September 23 forced the then Prime Minister, Liz Truss, to replace her finance minister Kwasi Kwarteng with seasoned politician Jeremy Hunt. However, that was not enough to stave off the pressure from within Truss’ own party, ultimately leading to her resignation on October 21 after just 44 days in the job. There followed a swift leadership campaign in which Rishi Sunak was decisively selected as Prime Minister; Sunak lost the previous leadership campaign to Truss standing on a markedly different economic agenda, and was known to be fiscally conservative during his time as finance minister in the Boris Johnson government.

The market reaction to Kwarteng’s ‘mini-Budget’, which featured the largest unfunded tax cuts since the 1970s, has been well documented, but is worth recapping for the extremity of the moves. Ten-year Gilt yields peaked at 4.60% and 30-year yields at 5.15%, and sterling at one point fell below 1.06 against the dollar. The sharp move in Gilts triggered collateral calls on the interest rate hedging positions of pension funds running liability driven investment (LDI) mandates, which caused further selling pressure across the whole fixed income market. The Bank of England came to the rescue, launching a ‘Gilt market operation’ under which it could purchase up to £65bn of long-dated Gilts and pausing its quantitative tightening (QT) programme. This bought the market some time, improving liquidity and allowing the selling to be conducted in a more orderly fashion. In total the BoE spent £19.3bn of its £65bn cap, which shows the extreme price moves had been exacerbated by the lack of liquidity. 

So as far as sterling assets are concerned, where are we now?

Hunt reversed almost all the tax cuts brought in by Kwarteng while Truss was still Prime Minister; cuts to the top rate of income tax and the dividend tax have been scrapped, VAT-free shopping for international tourists has been shelved and a planned hike in corporation tax has also been reinstated. In addition, the Energy Price Guarantee has been reduced from two years to six months, after which the benefit is expected to become means-tested. Sunak also retained Hunt as finance minister, giving investors the sort of continuity at the top of government that has been lacking in recent weeks.

The market reaction to Hunt’s sweeping reversals was very positive, with Gilts back to their ‘pre-Kwarteng’ levels of around 3.5% on the 10-year and 3.6% on the 30-year. Markets are now pricing in a UK terminal interest rate of 4.85%, down from 6.25% on September 27. The strength in rates has also fed into credit; last week sterling investment grade corporate bond spreads tightened 10-15bp and the BoE resumed its corporate QT programme, actively selling approximately £200m per week of sterling corporates. Many had rightly questioned whether pension funds, typically large buyers of long-dated sterling IG, would still have demand for these assets, but so far the signs are encouraging – the BoE’s sales have been well digested and long duration IG remains very well bid. In addition, following a dearth of non-financial issuance this year two IG sterling companies have successfully tested investors’ appetite for new bonds in the primary market. Northumbrian Water and Northern Ireland Electricity Networks, both rated BBB+, issued 12-year and 10-year bonds respectively with generous initial price guidance attracting impressive demand with order books 3x and 5x covered – quite a shift in sentiment from the beginning of October.

Overall, we see glimmers of positivity in the sterling market as we await the BoE policy decision on Thursday. Pension funds still have demand for long dated IG, a more natural fit for duration matching. Anecdotally, LDI mandates have bolstered their defences against a repeat of the extreme Gilt moves, reducing leverage from 3x to around 2x and their collateral buffer, which was 150-200bp at the start of the year but had been largely exhausted by June, has now been increased to 300bp. The BoE’s QT process will continue to test the appetite of the market but as we have seen, it is prepared to alter course should market dynamics shift. Sterling spreads offer an attractive premium (they remain around 20bp wide of their pre-Kwarteng levels) to the extent that they have now caught the eye of hedge funds and foreign investors. 

With Sunak seemingly regarded as a safe pair of hands, we await the Autumn Statement from Hunt on November 17, which will set out his tax and spending plans in more detail. While a number of global uncertainties remain across the macro picture, the sterling market can now expect more political stability with a focus on deficit reduction rather than growth. The UK uncertainty premium may not dissipate quickly, but when targeted via solid companies with sustainable revenues, in our view it increasingly appears to be overcompensating for the underlying risks.